According to a press release by the USDA entitled "The American Families Plan Honors America's Family Farms," states that the plan to close the stepped-up loophole in capital gains taxes will not impact family farms that stay in the family. While details are still lacking, the American Families Plan might reduce transfer taxes on family farms but could still increase the income tax these families will pay.
As the law exist currently, those inheriting farmland can increase the tax basis of property to fair market value without paying a capital gains tax, which is referred to as a step-up basis. The step-up basis is crucial for farmers and ranchers who have seen the value of family property increase dramatically, often over a span of decades. Though President Biden offers assurance that the American Families Plan (AFP) will not negatively impact America's farming and ranching families, the currently available details promote more questions than answers.
How Will the Proposed Changes Impact American Farms
The purpose of the American Families Plan is to foster middle-class prosperity while ensuring that the loopholes afforded to the wealthy are closed on a stepped-up basis. According to the USDA press release, the American Families Plan (AFP) will protect family farms and ranches by:
· The AFP includes special protection for both family-owned farms and businesses. The protection defers tax liability on family farms as long as the farm remains owned and operated by the family.
· Married couples will be granted an exclusion of the first $2 million of gains per couple, or up to $2.5 million if the farm also includes the family home, from capital gains. If heirs decide to sell the family farm, the first $2 million will be excluded from capital gains taxes.
The AFP promises to close loopholes in the tax code through three strategies.
1. Increase the enforcement activities of the IRS
2. Restore the top individual tax bracket to its pre Tax Cuts and Jobs Act of 2017 levels
3. Transform the tax treatment of a property that has appreciated at death, sale, or gift
As you might suspect, number three on the list is what concerns American farmers and ranchers. According to the press release, President Biden supports agriculture and recognizes the value of American farmers. However, as with most proposed tax reforms, the devil is often hidden in the details. Details are lacking at this time, as information about the proposed Plan is limited to a bulleted list and flowery language describing the benefits.
How Will The AFP Impact Families Passing Farm Land Down to the Next Generation
The actual legislative text will determine the ultimate impact of the AFP. Until then, much of what we know about the AFP can only be surmised by general language released by the Federal Government. While it is possible that at least $2 million of appreciation will be excluded from capital gains taxes, what happens to gains above that amount? Even if a small family farm saves on capital gains taxes, what about income taxes for those operating the family farm?
IRC § 1014(a) provides a current stepped-up basis to equal an inherited asset's value to its fair market price at the time of the decedent's death. The heirs' capital gain tax is minimized on assets that have increased over time between the purchase and the time the inheritance takes place. The American Families Plan will do away with the "step-up basis" benefit.
The Potential Negative Consequences of the American Families Plan on Family-Owned Farms and Businesses
The "stepped-up" basis or "step-up basis" benefit is, before all, an incentive for taxpayers on capital gain tax. One of the most concerning negative consequences for farming families will arise when heirs decide to stop farming the land, whether they sell or not. The special provision to protect family farms is limited to when the farm is owned and operated by the family. Once operations cease, the tax burden may be overwhelming, especially for heirs who do not wish to sell but no longer want to farm.
Under the AFP, the current information states that family-owned businesses and farms are exempt from taxes when passed to heirs who continue to operate the farm, ranch, or business. However, few details are provided. Land, the primary asset of most farms and ranches, has appreciated significantly in most geographical regions. Substantial income tax liability could require that farms and ranches sell assets to pay the increased income tax, hindering the ability of the farm to remain operational.
The USDA press release mentioned earlier indicates that 98% of farms will not owe taxes at the time of transfer, providing the farm stays operational and in the family. The things not discussed in the Plan are of the greatest concern to America's farming and ranching families. Concerns include:
· What happens during lapses in farming activity?
· What criteria will be used to define "operational"?
· Farms often experience transitional periods where farmland is rented to others instead of actively farmed by a family member. How will the AFP impact these situations?
· The potential for retroactive penalties and interests when farmland is no longer operational could spell disaster for many farms and ranches.
· IRC § 2032A is a current special use valuation enacted in 1976. However, the rules are complex, and the penalties for missteps are substantial. The section was implemented for agricultural landowners to use the value of their property based on its use value rather than development potential. There is concern over how the AFP will impact, or change, this provision.
· How will the AFP impact succession plans for non-farming heirs? It is common for parents to desire to leave an equal legacy to all their children. However, under the AFP, the non-farming heirs may have to pay a hefty capital gains tax on their portion of the inheritance.
· Multigenerational farms often do not operate with a straight line of succession. How will the final American Families Plan define family? What will happen to nieces, nephews, and cousins with a vested interest in the family farm's future?
· For many multigenerational farmers, their retirement plan is often a section of farmland. How will these transfers of property be impacted under the proposed AFP?
An Example of a Practical Consequence of the AFP
Joe owns 1,000 acres of Ohio farmland, which is rented to his brother-in-law. The rental income generates $250,000 annual rental income. Under the current law, this income is subject to the Net Investment Income Tax (NIIT). If the AFP goes into effect, Joe will owe an extra $9,500 in income tax.
Another example assumes the same land and value, but Joe farms the land himself. He dies, and his son inherits the land. The son farms the land for a decade but decides to pursue another career. He does not wish to sell the land where his family lives but does want to retire from farming. Under the AFP, the son may find himself facing a hefty capital gains tax, with interest and penalties, from the time of Joe's death. He may have no choice but to sell all or part of the land to pay the tax bill. The AFP could pose a genuine threat to generational farming, forcing heirs to sell the family farm instead of risking an unpayable tax bill in the future.
Final Thoughts on the AFP's Impact on Farm Families
Proactive steps to avoid some of the negative consequences of the AFP will depend on the final legislative language. The increased child tax credits, free college education, and reduced child care expenses will likely benefit young farmers with children. However, the current consensus is that almost all other ranchers and farmers will see a net tax increase. The most likely avenue for the increase will be extra income taxes, loss of certain deductions, and additional taxes on property transfers when passing property to the next generation.
The Plan may be called the American Families Plan, but America's farm families are likely to see an increased tax burden. The multigenerational farm is already struggling, and the AFP will add another burden to families trying to draw a living from the land.
Though the American Families Plan will be debated in Congress for the foreseeable future, and changes to the Plan are to be expected, farmers are encouraged to talk to their tax advisors and estate planning attorneys now. Now is the time for cautious preparedness, as it may be prudent to take steps now to protect yourself and your family from upcoming changes that could negatively impact your tax liability and succession plan.
James Schroeder is an attorney licensed to practice in Ohio, Pennsylvania, New York, New Jersey and the District of Columbia and maintains an office in Sardinia. You may reach him at (973) 886-4563 or at southwestohiolaw.com.